Question

How to estimate the DCF cost of equity if dividends are not growing at a constant rate? (detailed explanation needed)

I found short answer on Internet for this as: "We will find the PV of the dividends during the nonconstant growth period and add this value to the PV of the series of inflows when growth is assumed to become constant. " But I'm looking for a detailed explanation.

Answer 1

One should estimate the DCF cost of equity making use of CAPM, if dividends are not growing at a constant rate,

Capital asset pricing model (CAPM) return

This model is not new to us. Enough has been discussed about this. We simply state the equation:

The general idea behind CAPM is that investors need to be compensated in two ways – the time value of money and risk Time value of money: The time value of money is represented by the risk-free rate in the formula and compensates the investors for placing money in any investment over a period of time. Risk: The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking β that compares the returns of the asset to the market over a period of time and to the market premium E(Rm) – Rf.

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. While there is nothing risk free, any security backed by the government (Treasury bills, notes, bonds) is considered to be risk free. Government securities are considered to be risk free because a government is never expected to default. If it runs out of money or is on the verge of default, it can always print money or increase the level of direct and / or indirect taxes in the country, collect the money from you and give it back to you. Hence risk free rate should be surrogated by the yield on government securities. Stock market can be taken as a surrogate of market and historical return from the stock market of a company over a long period of time can be taken as a measure of expected return from the market. Historical equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium. Stock market return in excess of risk free rate is market premium and β times market premium is the expected premium from the security. Expected return from a security as calculated by using CAPM equation is also the expected risk adjusted return (a return adjusted for its risk).